China Credit Crunch – it’s the central bank, stupid!

The New York Times reports on the Chinese financial market mentioning a credit crunch. However, it seems that the credit crunch is the equivalent of rising interest rates and nothing out of the ordinary:

“China’s central bank, by allowing a spike in interbank rates to persist for longer than usual, is sending a message to the market that liquidity needs to tighten and credit growth slow at the margin,” Andrew Batson and Joyce Poon, analysts at GaveKal Dragonomics, wrote Thursday in a research note. “Indeed, the central bank has been using its open-market operations to drain liquidity from the interbank market since January, setting the stage for just this kind of showdown with banks.”

In a recent paper with Finn Körner I have analyzed the Chinese interbank market. Here is an excerpt:

Now, as everywhere, rules are there to warrant exceptions. The rules in China are as follows according to a Japanese Ministry of Finance analysis (IIMA 2004, 26):

“In HVPS [High-Value Payment System], financial institutions must cancel payment instructions in the queue by 6:00 p.m., or credit them via HVPS after raising funds from other branches. When an overdraft is not compensated by 6:00 p.m., the unpaid payment instruction in HVPS will be compulsorily returned to the sending bank. If payment is not completed in BEPS [Bulk-Entry Payment System] or LCHS [regional payment systems], PBC will apply a penalty interest rate to financial institutions with overdrafts, and extend an overnight credit.”

A bank in overdraft will lose money from lending activities if its marginal credit margin is below the penalty rate. It would then be in the interest of the bank to reduce its loan portfolio in order not to end up short on reserves for the central bank. As the end-of-quarter deadline to deliver the reserves to the PBoC approaches, the interbank market interest rate can be expected to spike upwards if the total amount of reserves in the system is too low. More precisely, the interest rate will approach the penalty rate on overdrafts. This is just the mechanism Fullwiler (2010, 4) described: reserves do not create loans, they are rather the required ex-post financing condition validating all granted loans.

So, it seems that the People’s Bank of China (PBoC) is fighting credit growth. This could be part of a rebalancing strategy that will lead China towards a domestic demand-led growth system. In order to free up capacity for more consumption a fall in investment must be brought about. Since loans finance investment, a fall in loans must be brought about. Since the reserve ratio hasn’t worked well lately, it seems that the PBoC has changed its tactics and is now using open market operations to limit liquidity in the financial sector. This probably has spurred financial “innovation” (circumvention of regulation) as banks try to minimize the amount of reserves needed to sustain a given debt structure. Apparently, the regulator has the upper hand against the “innovators” – for now.